Political risks will deepen eurozone woes

For those who had hoped we might slowly leave the Great Recession behind, this week brought bad news on both sides of the Atlantic. In the US, the government shutdown after Republicans and Democrats failed to reach an agreement on the budget. However, as in previous US budget clashes, this may only be a temporary blockage.

From a global economic perspective, far more worrying is what is happening in Europe. Though the euro crisis had been tranquilised during the German election campaign, a week after Chancellor Merkel’s election victory saw old European problems resurface and and some new issues appear on the horizon.

They all have a common denominator: political risk is back on the agenda. The political situation in many European countries is fragile. This has implications for the future of monetary union as it both increases the risk of market fears and decreases the ability of European policymakers to restore confidence. We are heading into a new phase of uncertainty.

Last week, European markets wobbled when Italy’s government started to disintegrate. Yields on Italian government bonds have risen sharply over the past week while the Italian stock market suffered losses.

The reasons, as always, are the latest manoeuvres by former Prime Minister Silvio Berlusconi. Fighting his expulsion from the senate for having been convicted of tax fraud, the Cavaliere had ordered his party’s ministers to resign from the government. This forced Italian Prime Minister Enrico Letta to call a vote of confidence.

No matter how this vote will play out (at the time of writing the result was not yet known), two things are clear. Italy’s political situation remains complicated; and Berlusconi, discredited and convicted as he may be, is still a force to be reckoned with.

This is bad news for the euro crisis. Although several safety nets are in place now that weren’t during earlier stages of the crisis – chief among them the European Stability Mechanism and the European Central Bank’s Outright Monetary Transactions program – they will not be able to stem an Italian crisis.

Italy is not only too big to fail, it is also too big to be rescued. The eurozone’s third largest economy after Germany and France carries government debt of €2.1 trillion ($A3.03 trillion), while the Italian treasury has forecast Italy’s debt to reach 132 per cent of GDP by 2014. It may have been possible to keep Greece, Ireland, Portugal and Cyprus afloat for a while. Once Italy needs life support, it would be game over. No matter how much political will could be assembled, the sums needed to stabilise Italy are too large.

But even the political will to save the Euro at all costs needs to be questioned anew after last weekend’s Austrian elections. Austria may be small and relatively unimportant in the grand scheme of EU things (though don’t you dare tell the Austrians about it). It is, nevertheless, part of the euro core that is backing Europe’s bailout policies.

What happened in Austria was a remarkable electoral success of parties that are hostile to the euro bailout policies. The Freiheitliche Partei Österreichs (FPÖ, ‘Austrian Freedom Party’) became the third largest political force at 21.4 per cent of the vote. A new populist party led by Austro-Canadian billionaire Frank Stronach (Team Stronach) won 5.8 per cent, and the equally populist Bündnis Zukunft Österreich (BZÖ, ‘Alliance for the Future of Austria’) scored 3.6 per cent but failed to win any seats in parliament. In total, 30.8 per cent of Austrians voted for parties committed to fight the European Stability Mechanism and promote Austria’s exit from the eurozone.

In practical terms, it may not matter immediately since social democrats (SPÖ) and conservatives (ÖVP) still managed to win a small parliamentary majority. However, it was the lowest combined SPÖ/ÖVP share of the vote in Austrian history. Both parties used to dominate Austrian politics for decades; now they are only narrowly clinging on to power together.

What is happening in Austria should not be underestimated. Austria may be a small country but it could also trigger a domino effect. With anti-euro parties now playing an important role in Austrian politics, the future Austrian government will be forced to be tougher on European bailout policies by threating to withdraw from them. The consequences of such a withdrawal could be severe. Say Austria decided not to support a new bailout round for Greece or Cyprus, why would Finland remain committed? Or the Netherlands? Or indeed Germany?

Talking about Germany, not even Germany is immune from the spreading virus of political risk. Angela Merkel may have celebrated her electoral victory but it is becoming clear what an unpleasant situation it has left behind. Her Christian Democrats need a new coalition partner after the Free Democrats had been kicked out of parliament.

The Social Democrats have agreed to negotiate with Merkel on forming such a coalition. At the same time, they will let their party members (almost half a million of them) vote on the final result of these coalition talks. It is well known that a large majority of the Social Democrats grassroots reject any coalition with Merkel. This could mean that after weeks of post-election talks, no new government could be formed and, in a worst case scenario, Germany might need to go back to the polls. The results of such a new poll would be unpredictable. They might well strengthen Merkel, return her old Free Democrats coalition partner to parliament, or see the rise of Germany’s own eurosceptic movement, the Alternative für Deutschland.

There are question marks hanging over European politics, not just in Italy, Austria and Germany. But uncertainties are the things that markets appreciate least. At a time when many observers were expecting the next steps in the euro crisis such as the establishment of a ‘banking union’ and the next packages for Greece, Cyprus and Portugal, the political situation has become more complicated.

In comparison with Europe’s problems, the US government shutdown almost looks straightforward. It will no doubt be easier to solve. For Europe, on the other hand, difficult times lie ahead.